Brazil: A Case Study in Sticky Stagflation

Conclusion: Sticky Stagflation and FX headwinds should continue to weigh on Brazilian equities – which are flirting with a TRADE-line breakdown – over the intermediate-term TREND.

On December 17thof 2010, we published a research note titled, Brazil: A Leading Indicator for the Global Economy?. The conclusion of the note was as follows:

“Looking under the hood of the Brazilian economy and stock market, we see more confirmation of Accelerating Inflation and Slowing Growth on a global basis. Given, we expect both emerging market bonds and equities to underperform as an asset class in 1H11.”

The purpose of flagging this isn’t at all to take a victory lap, as our team full of washed-up collegiate athletes is prone to do. Rather, it is merely to highlight the sheer amount of time that economic fundamentals can remain supportive or unsupportive of certain markets and/or asset classes. Consensus can remain right for longer than we’ve been trained to anticipate.

As institutional investors, we systematically choose to fade visible fundamentals in expectation that whatever news (good or bad) will eventually become priced in before the river card is revealed. This technique is certainly one that has been good to a great deal of investors, but today, Brazil is reminding us all that when growth is slowing and inflation remains sticky, valuation remains no catalyst on the long side. Furthermore, bad news/data can remain a headwind for a lot longer than we are paid to hope.

Brazil Cuts Rates Again

Consistent with our view that the King Dollar will receive a bid from monetary easing across the world – particularly in emerging markets – over the next 3-6 months, Banco Sentral do Brasil lowered the country’s benchmark interest rate, the SELIC, to 11.5%. This is the second cut YTD, after a -50bps reduction at the end of August. After eight hikes worth a cumulative +375bps in the recent tightening cycle, this latest cut is confirmation that the central bank is committed to its newly-adopted policy of lowering the country’s aggregate interest rate burden.

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The central bank, which has repeatedly cited slower global growth and the potential for a Eurozone banking/sovereign debt crisis to send the world into another recession, may not be acting solely with the purpose of preemptively buffering Brazil’s economic growth. In recent months, there has been an immense amount of highly-publicized political pressure emanating from President Rousseff and her cabinet upon the central bank, now headed by Rousseff appointee Alexandre Tombini, to lower rates (email us for our expanded thoughts on this topic).

It’s worth highlighting that Brazil, which runs a primary budget surplus of 2-4% of GDP consistently runs a budget deficit in the 2-4% (of GDP) range – meaning that interest costs alone are roughly 4-6% of GDP on average. Rousseff, a self-proclaimed “woman of the people” would much prefer to use the interest expense savings on social spending, in addition to allocating more funds towards the government’s planned infrastructure initiatives over the next 2-4 years (email us for a copy of our Brazil Black Book, where we detail Brazil’s long-term infrastructure needs and plans).

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Was It the Right Thing To Do?
Needless to say, with inflation at a six-year high of +7.3% YoY in September and, more importantly, directionally divergent from the central bank’s prior expectations of an August peak, the central bank’s rate cuts are making the more hawkish members of Brazil’s political and investment communities rather nervous. For example, inflation expectations as measured by the central bank’s weekly economist survey expect the country to miss the central bank’s 4.5% (+/- 200bps) inflation target this year for the first time since 2003. Moreover, they are now forecasting consumer prices to rise 5.61% in 2012 – a new YTD high.

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We don’t really put much stock in economists or consensus numbers; we do, however, trust in [at least] the conviction behind forecasts when capital is at risk. For a more market-oriented measure of inflation expectations, we turn to the spread between inflation-linked bonds and interest rate futures as a gauge of what investors believe Brazil’s benchmark IPCA CPI index will average in a given period. On the two-year maturity, Brazil’s breakeven spread has widened +30bps since Aug 31st(the date of the previous SELIC cut). As the chart below shows, this contrasts with Brazil’s regional peers such as Chile and Mexico, who saw similar measures decline over that duration.

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Uncontained loan growth and the potential for the government to overextend itself in the upcoming fiscal year are also supportive of rising inflation expectations. In the year-to-date through August, domestic credit is growing at an average rate of +20.4% YoY – 340bps higher than the central bank’s upwardly-revised forecast of 17%. Moreover, next year a roughly +14% increase in the country’s minimum wage and [already generous] pension payments – which are already the government’s largest expenditure by line item – should at the very least keep a floor under the demand-pull side of the inflation calculation in Brazil.

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Nevertheless, the central bank remains committed to its goal of lowering inflation to the mid-point of its target by year-end 2012 – at least per the rhetoric from Tombini & Co. As highlighted above, it remains to be seen whether or not he’ll be able to meet that expectation by many in and around the Brazilian economy.

Brazil is country with a history of policy blunders, having seen a cumulative 13.3 trillion percent of inflation in the 15 years before the 1994 Real Plan (per Bloomberg). CPI, as measured by the benchmark IPCA index topped +17% on a YoY basis as recently as May ’03, meaning there are a lot people in the country who vividly remember the days of helplessly watching their life savings disappear on a real basis. As such, both the central bank and the government will be under enormous pressure from both markets and voters to make sure their forecasts for CPI prove accurate.

Risk Management Setup

From our perspective, the long and short of the situation in Brazil remains what it has been since we turned bearish on the country in 4Q10. While inflation is likely to have peaked in September according to our models, it is equally as likely to remain elevated and strictly over the intermediate term. Further, we see no reprieve on the growth front until at least a potential bottom in 1Q12E. There’s a lot of risk to manage in between now and then – assuming more recent data (the latest GDP report out is 2Q11) doesn’t push that catalyst farther out in duration.

Moreover, our high-conviction Key Macro Themes of King Dollar and Deflating the Inflation should continue to put downward pressure on the Brazilian real vs. the U.S. Dollar (BRL/USD), as rate cuts will erode demand for Brazilian assets on the margin and falling commodity prices (roughly half of Brazilian exports) will limit both demand for reais in the international marketplace and lower the government’s revenue – potentially eating away at its good-but-not-great fiscal positioning. As an aside, a Senate budget committee recently scored President Rousseff’s 2012 budget and decided that the deficit was likely to come in R$25.6 billion higher than expected due her overstating growth by 50bps (Senate 2012 GDP forecast is at 4.5% vs. Rousseff/Mantega at 5%).

Net-net-net, slowing growth and sticky inflation = Sticky Stagflation and that’s not something we expect many investors to find attractive. Moreover, both monetary and fiscal policy are proving to be incrementally negative for the Brazilian real (BRL/USD is down -12.3% over the last 3mo), another headwind to investing in Brazilian stocks for a U.S. domiciled investor. We expect these fundamentals to continue to weigh on Brazilian equities – which are flirting with a TRADE-line breakdown – over the intermediate-term TREND.

Darius Dale


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